Understanding a bank’s balance sheet

In this article I will take you through the basics of a bank’s balance sheet.

Why should an investor consider banks?

Good bank stocks can be great wealth creators. For example, HDFC Bank stock traded at Rs. 45.65 (after adjusting for corporate actions like splits) in Dec 2000. Today it trades at around Rs. 690. This works out to a compounded annual return of around 23%.

When you look at stocks it is good to see the demand in the sector first. Next you can look at the competitive positioning of different companies in that sector.

In an under-banked country like India, the banking sector has miles to go before we see saturation.

A bank is very different as compared to a manufacturing or services business. This is also why banks are studied separately along with typical parameters and ratios which you might not see in a company from outside the banking and non-banking financial company (NBFC) sector.

A bank is an intermediary which channels money from depositors and lends it to individual and corporate borrowers. It makes money on the spread between what it pays to depositors and what it earns when it makes a loan (also may be called as an advance). In the last decade we have seen the rise of “fee income” apart from the core income on loans. It now makes up a relatively large portion of a bank’s income as compared to a decade agao. Examples of fee income could be money earned because of late fees on credit cards and loan processing fees respectively.

Assets in a bank’s balance sheet

Cash is self explanatory.

SLR stands for Statutory Liquidity Ratio. SLR is prescribed by the Reserve Bank of India. A bank is expected to hold a certain ratio (presently 23%) of their Net Demand and Time Liabilities (NDTL) in approved securities like government securities, cash or gold. I suggest reading this link by IDFC MF on Net Demand and Time Liabilities to understand NDTL better.

RIDF stands for Rural Infrastructure Development Fund which is set up by the Government of India. Banks are expected to deploy money towards the RIDF to the extent they lend less towards agriculture as compared to mandated lending requirements.

Advances – This is the most important heads on the asset side. This talks of the core business of a bank. This is also called the loan book. Banks report the breakup of their loan book by borrower type (retail, small and medium enterprises (SME) and large corporates). They also usually report the sector-wise breakup of their loan book.

Liabilities on a bank’s balance sheet

Net worth is the shareholders’ capital in the bank. This is also called as the book value of a bank. As is the case for any business in general, a shareholder would like to see a growing book value year on year. This is what is left if one subtracts all the other liabilities from the assets side.

Deposits is a key item in the liabilities. This is part of the core business of intermediation of capital – borrow from depositors and lend to borrowers. Deposits are broadly of three kinds.

Savings accounts – Depositors receive 4% or higher. Recently the RBI has deregulated savings bank account interest rates and we have seen some banks offer rates of around 6% which is 50% more than the 4% that depositors would receive earlier. Money in savings accounts can be withdrawn at any time. It does not have an associated time period.

Current accounts – Used by companies. A bank does not pay interest on current accounts.

Others – Fixed deposits and the like where depositors receive higher interest than a savings bank account. They have a definite time period and usually there are penalties in place for premature withdrawal.

Borrowings are made up of bonds, debentures and certificates of deposit where the bank borrows money of varying tenor.

One should look at the deposits and borrowings from the perspective of respective interest rates and corresponding cash inflow and outflow for the bank. If you were the owner of a bank you would like to pay the least amount of money on your deposits and borrowings.

CASA – Current account, savings account

CASA is a commonly used parameter that is used to understand the amount of liabilities that the bank pays relatively less interest on. The higher the amount of CASA as a percentage of total liabilities, the lesser will be the interest paid by the bank.

Investors should look at the CASA numbers carefully, as CASA is a source of strength for the bank. For example, ICICI Bank is considered to have a comparatively healthy CASA percentage.

Deposits

Rs. In cr.

%

– Others

1751.38

56.7%

– Savings

935.35

30.3%

– Current

403.73

13.1%

Total

3090.46

100.0%

The CASA deposits add up to around 43% of their total deposits.

Non-performing assets – NPA

Basically, NPAs are advances made by the bank on which borrowers are not paying interest payments or principal repayments on time. The RBI has standards for NPA classification that dictate when a “standard” bank loan becomes an NPA.

An advance can become an NPA and come back on track too.

On recognition of an NPA the bank has to make “provisions” which are deducted from the income. This is to account for the probability that the money lent out might not come back. I will discuss more on this in the next in the bank analysis series when I cover profit and loss statements for banks,

Why should an investor look carefully at NPAs?

Think of debt to equity ratios in a manufacturing company for example. If D/E ratio goes above 1, investors get cautious. Figures above 1.5 indicate cause for worry.

Now, consider the debt to equity ratio in a bank.

Look at ICICI Bank’s leverage.

I add the Deposits and Borrowings together and get a figure of Rs. 4544 cr.

Divide this by the Net Worth of Rs. 731 cr and we get a D/E ratio of 6.2.

If you have not seen a bank balance sheet before this will seem shocking. This would never be seen in typical manufacturing companies. Not even in normal infrastructure or project finance cases which can see high debt equity ratios of 3:1.

This is the reason why banks are regulated by the central bank, the RBI. They operate with very high leverage as compared to companies in other industry sectors.

Any company operating with high leverage usually has less room for error. Leverage is a double edged sword. It can give you high returns or high losses. All banks live by this rule.

So, we come back to the NPA issue.

Consider the balance sheet shown above. Suppose that 2% of the advances on this balance sheet go bad and end up as NPAs because the borrowers cannot make payments to the bank.

2% of Advances works out to around Rs. 64 crore. This seems like a small amount. Let us compare this Rs. 64 crore to the shareholders capital in the bank, also the book value. Book value stands at Rs. 731 crore.

2% NPAs work out to 8.7% of ICICI Bank’s book value or net worth.

You will now appreciate that the NPA numbers in the headlines seem low. When you re-frame the context as damage to book value you get the true picture.

Presently, the banking sector is facing stress as a slowing economy puts pressure on borrowers, with some defaulting. Private and public sector banks are seeing rising NPA levels. PSU banks are comparatively harder hit as they are widely believed to have deficient lending standards as compared to their private sector counterparts.

This recent article in the Hindu Businessline talks of the problem of rising bad loans.

If there is a hole in the balance sheet, it has to be filled. One way it can be filled up is with the profits left after paying dividends. In bad times profit growth reduces so it does not help the situation to a great extent.

The other usual way is to raise equity capital.

This dilution is a big risk to a bank investor. The earnings now get distributed over a larger number of shares and thus earnings per share (EPS) is affected negatively.

A bank that has bad loans and attendant capital problems cannot grow its loan book as well as healthy counterparts. This is because they face regulatory pressure.

This brings us to the next topic.

Capital Adequacy Ratio

The Basel reforms stipulate that a bank should maintain adequate capital against its assets. This is because banks are systemically important institutions. If one bank sees trouble, contagion spreads in the financial system because of the financial inter-linkages. We have seen this happening in the 2008 credit crisis in the global economy.

The regulator places different types of assets in different buckets depending on how risky they are. Different buckets have different risk weights to quantify the risk.

ICICI presentation on September 2013 results

You can also visit the ICICI Bank Investor Relations page. In the Quarterly Financial Results page, read an analyst call transcript and read the management’s talk about the company’s results. Get familiar with banking terms and issues.

Continue reading

Read the next article and understand a bank’s income statement (or profit and loss statement) in in the series on understanding bank stocks. After that I will write an article in which I will describe how to look at the complete financials of a bank and how to value banks.

Hope you had a good time reading this article on bank balance sheets. Let me know your views.

About Kunal Pawaskar

Comments

Againa good article and really look forward to you note on valuation of banks.

One question, to calcualte CAR, do banks generally take all asets (san equity investments and fixed assets i guess) and asign risk weights accordingly to calculate RWA? But what “Total capital” consist of in this case? Only equity capital?

Investing in company deposits (NBFCs and manufacturing units) is a good option for a common man for investment. However a care hs to be taken in choosing a good company. The choice of the company can be made by various ratings awarded to the companies byCARE/CRISIL/ICRA/BRICKWORK etc. But the common man does not know from where to obtain the ratings. He also does not know the meanings of the shortforms of the ratings. Therefore please explore as to whether a study course can be worked upon for the benefit of the investor.

Hi Venkatesh, I believe it is better to get the benefit of diversification through a debt mutual fund rather than investing in 2-3 fixed deposits of companies respectively (which is what most investors do). There are umpteen cases in India of companies which do not repay fixed deposits. It is a risky affair. These are my views.

Investing in company deposits (NBFCs and manufacturing units) is a good option for a common man for investment. However a care hs to be taken in choosing a good company. The choice of the company can be made by various ratings awarded to the companies byCARE/CRISIL/ICRA/BRICKWORK etc. But the common man does not know from where to obtain the ratings. He also does not know the meanings of the shortforms of the ratings. Therefore please explore as to whether a study course can be worked upon for the benefit of the investor.

Very timely article Kunal. Currently I am analyzing Shriram Transport and have difficulty in understanding few things

1) Key parameters like NPA and yield should be calculated on book assets or total assets including off BS items? I noticed that companies report NPA only for AuM on balance sheet. Then what about NPAs on securitisation. STFC do make provision for securitised assets too.
2) Leverage and opex expenses as % of AuM including securitization or excluding it.
3) Accounting of NPAs – provision for NPAs can get distorted by discretionary write off of bad debts. How to detect this?

For the benefit of other readers, I will just add a note here that you are talking of a company that securitizes a portion of their originated loans.
What is Securitization? Link – https://en.wikipedia.org/wiki/Securitization

For securitization cases specifically, where gross assets under management (AUM) are higher than on book AUM, NPAs are taken on the on book portion. You are right. The entity which securitizes loans is expected to keep a portion of the securitized loans on their books under Minimum Retention Requirement (MRR) rules. This will be on book. This also will attract provisions.

Similarly with yields you would do calculations on the assets that are on books.

2. Leverage and Operational expenses
Take AUM on books.

3. This applies more broadly to banks and NBFCs respectively. This is something the RBI is concerned about too. That banks are writing off bad debts without making earnest efforts to recover the bad loans.

“There is evidence of increased use of write offs by banks to reduce NPAs, which is a pointer to weaknesses in credit management. Write offs were initially introduced as a tool for banks to manage their tax liabilities on impaired assets. However, they subsequently emerged as a tool for banks to manage their reported gross NPA numbers. Write offs, in fact, contributed significantly to the reduction in the quantum of gross NPAs (in some years, write offs accounted for nearly 50 per cent of reduction) as compared to actual recoveries and upgradations. Write offs as a percentage of terminal reduction (reduction on account of write-offs and actual recovery alone) has consistently been above 50 per cent mark (Annex 4).
23. These practices clearly engender moral hazard issues as they reduce the banks’ drive to improve recovery efforts. They also result in leakages in the recovery process. This is evidenced by the fact that, on an average, less than 10 per cent of the total amount written off (including the technical write off) is recovered (Table 4).”

From the address delivered by Dr. K. C. Chakrabarty, Deputy Governor, Reserve Bank of India at
BANCON 2013 on November 16, 2011in Mumbai

This can be seen in the disclosures made by the banks – investor presentations / earnings call transcripts. This is slightly harder to find in presentations. This is answered in the calls if an investor / analyst asks.

Fortunately, I got many more answer related to securitization in some transcript call of Shriram Transport. I have posted this doc on another forum too, thought it might be beneficial to your reader too. That doc that be downloaded from below link….

If I take into account the combination of conservative mgmt which believes in guarded profitable growth which can deliver better returns than other possible avenues as opposed to increasing top line even if it means margin erosion (ala MMFSL) and the stage at which the Indian economy is (compared to more mature ones like US/EU and the contribution of transport financing to overall GDP) I believe in STFC. I also like the attractive price (as I am truly a long term investor) is available now a days. I like their model of starting small in a region first to understand the local dynamics before expanding (as they are doing now in North and West).

Lately, IT has also started playing a big role in their growth. For example the number of customers a field officer can manage and serve has increased from 75 (5 years ago) to 150 (2013). I think with the new IT platform they have put in, this can increase. The back-office is like a Insurance company (with Securitization, etc) while the front-office is like micro-finance (before Micro-Finance became a bad word in our markets). Their bad loans are lesser than market average (watching GNPAs closely). Automalls will add volume.

The generational leadership change also seems to be going smoothly but NIMs have to be watched closely till the economy recovers. I think it will be around Oct/Nov 2014 when we can start to see some growth for this company.

Nice explanations. I have come across one point while reading HFC report – it says “The company sells the loans to the bank which use about 50% of such loans to reach priority sector lending targets mandated by RBI. this is one of the cheapest funding for the company.”

Priority sector lending is mandated by the RBI. Certain banks might not be able to meet such lending targets. They can buy loans from other banks who have the necessary infrastructure and credit underwriting capability to extend such loans. This would be what is being talked off in the report that you have quoted from.

2 questions :
1. Where are the provisions reflected in the balance sheet? Does the bank’s book value include provisions ?
2. What happens to the provisions when the asset gets healthy? Is it reflected in the P&L or the Balance Sheet?